2019 Year in Review: U.S. Private Fund Manager Regulation

During 2019, U.S. private fund manager regulation saw significant developments as well as continued SEC examination and enforcement scrutiny. Highlights of those developments include:

• Several SEC enforcement actions against private fund managers generally involving similar issues raised by the SEC in previous years;
• A formal SEC interpretation of fiduciary obligations of investment advisers;
• Proposed changes to the advertising rule under the Investment Advisers Act of 1940 (the “Advisers Act”), which could have a significant impact on private fund advertising (e.g., PPMs and pitch books); and
• Proposed changes to Regulation D under the Securities Act of 1933 (“Regulation D”) that would increase the pool of “accredited investors” permitted to invest in private funds, including knowledgeable employees of private fund managers and certain additional entity investors.

This KirklandPEN describes those and other developments.

SEC Enforcement Trends and Developments

Enforcement Activity Involving Private Fund Managers. In 2019, the SEC continued to bring significant enforcement actions against private fund managers, including the following:

• Allocation of Expenses Between Manager and Fund; Unauthorized Loan; Misuse of Fund Assets: In May 2019, the SEC settled charges with a private fund manager over improper expense allocation practices and the misuse of fund assets, where the manager (i) retroactively implemented a management fee waiver provision provided for in a fund’s governing documents without also retroactively applying a management fee offset provision included in the governing documents; (ii) borrowed from a fund on an interest-free basis to pay for the manager’s advisory operations without proper authorization; and (iii) caused a fund to overpay organizational expenses by requiring the fund to pay estimated expenses before such expenses were actually incurred and by misclassifying certain expenses as organizational expenses.
• Overcharging of Management Fees: In September 2019, the SEC settled charges with a private fund manager for failing to adjust the amount of a fund’s total invested capital, which was used as the basis for the manager’s percentage-based management fee, to reflect the write-off of a portfolio investment as required by the fund’s governing documents. 
• Improper Valuation Practices: In June 2019, the SEC settled charges with a private fund manager over its failure to implement adequate valuation policies and procedures, noting in the consent order that the manager’s valuation policies failed to ensure valuations were GAAP compliant and lacked sufficient means to oversee personnel performing valuations after the manager’s CIO approved valuations that traders noted were “undervalued” and included notations to “mark-up gradually” rather than marking-to-market. In the SEC’s view, this practice allowed the manager to sell assets for a profit when needed and correspondingly show better performance.
• Custody Rule Violations: In 2019, the SEC brought multiple cases against private fund managers in connection with violations of the custody rule under the Advisers Act. In March 2019, the SEC settled charges with a private fund manager for incorrectly stating in its Form ADV filings over a ten-year period that it did not have custody of client assets and failing to retain an independent public accountant to either perform an annual audit of its private funds or conduct an annual surprise examination in accordance with the custody rule over such ten-year period. In May 2019, the SEC settled charges with a private fund manager for failing to timely deliver audited financial statements to fund investors for a three-year period.
• Auditor Independence Issues: In August 2019, the SEC settled charges with a public accounting firm over violations of auditor independence rules, including in connection with the firm’s engagement by multiple private fund managers to perform custody rule audits for such managers’ private funds. The SEC noted in its consent order that the auditor was not independent from such managers because of certain non-audit services provided to the managers or their portfolio companies.

SEC Chairman’s Statement Regarding Offers of Settlement. In July 2019, the SEC Chairman issued a statement discussing the factors that drive appropriate settlements in connection with SEC enforcement actions and discussed the collateral consequences of certain settlements, namely, the possibility that the terms of a settlement, absent a corresponding waiver, may subject a party to significant disqualifications (e.g., prohibition on conducting Regulation D private placements). The statement noted that, in recent years, simultaneous offers of settlement and requests for disqualification waivers have generally been considered by the SEC on a separate basis by the SEC’s Division of Enforcement and Division of Corporate Finance, respectively, and indicated that, going forward, an offer of settlement that includes a simultaneous waiver request will be considered by the SEC as a single recommendation. This policy change may add more certainty to the waiver request process over time, but it is yet to be seen whether this will make it more or less likely for waiver requests to be granted.

SEC’s Interpretation of the Standard of Conduct for Investment Advisers¹

In July 2019, the SEC adopted a long-anticipated interpretation intended to reaffirm and clarify the standards of conduct regarding an investment adviser’s fiduciary duties to its clients (e.g., private funds) under the Advisers Act and to set out principles regarding such standards of conduct, conflicts of interest and disclosure obligations, including the following highlights for private fund managers:

• Duty of Care. The SEC reaffirmed that a private fund manager’s duty of care includes the duty to:
  • Provide advice that is in the best interest of each of its funds, which involves having a reasonable understanding of each fund’s stated guidelines and objectives (e.g., as stated in the fund’s PPM and other governing documents) so that the manager’s advice is consistent with such stated guidelines and objectives; and
  • Act and provide advice and monitoring over the course of the advisory relationship (e.g., the life of a fund) at a frequency commensurate with the agreed upon relationship, including as described in a fund’s PPM and other governing documents. The SEC views this duty as heightened in cases where the advisory relationship is ongoing and the manager is compensated with a periodic, asset-based fee (e.g., management fee) as is the case with most private funds.²
• Duty of Loyalty. The SEC reaffirmed that a private fund manager’s duty of loyalty includes the duty to:
  • Make full and fair disclosure of all material facts relating to the manager’s advisory relationship with a fund; and
  • Eliminate, or at least disclose to fund investors, all conflicts of interest that might cause the manager to provide advice that is not disinterested. The interpretation noted that full and fair disclosure does not require a manager to make an affirmative determination that a fund’s investors understood the disclosure and that any consent given was informed; rather, the SEC expects managers to provide disclosure designed to put fund investors in a position to be able to understand and provide informed consent to the relevant conflicts, with an emphasis on detailed disclosure.³

Proposed Amendments to the Advertising Rule⁴

In November 2019, the SEC proposed amendments to the advertising rule under the Advisers Act. If adopted, the proposed changes would significantly impact how private funds are marketed. Highlights of the proposed changes applicable to private fund managers include:

• Implementing a “principles-based approach” to advertising content in lieu of certain technical restrictions contained in the current rule and numerous SEC no-action letters. This proposed change is broadly designed to prevent fraudulent, deceptive or manipulative acts in connection with advertising and to ensure information is presented in a fair and balanced manner;
• Broadening and modernizing the definition of “advertisement,” including, for example, by extending the definition to include communications made via modern electronic mediums (e.g., email, text, social media, website), to a single person and/or by a third party on behalf of a manager;
• Permitting different track record information in advertising materials based on whether the recipient is a retail or non-retail investor.⁵ For example, advertising materials provided to retail investors would be prohibited from including:
  • Gross performance without also including net performance (shown with equal prominence) and a schedule of fees and expenses deducted to calculate net performance (or an offer by the manager to provide such schedule);
  • Any performance without also including the 1-, 5- and 10-year performance of the fund and any related funds;
  • Prior fund performance without also including the performance of all substantially similar prior funds;
  • Subsets of performance without also including performance for all investments in the fund(s) from which the subset was selected (or an offer by the manager to provide such information); and
  • Hypothetical performance (including targeted and projected performance), except where the manager adopts relevant policies and procedures and makes certain mandated disclosures;
• Adjusting the current no-action position regarding unsolicited diligence materials to require that any responses to (i) diligence requests made by retail investors that include any performance information or (ii) diligence requests made by any investor that include hypothetical performance information be subject to the requirements of the revised advertising rule;
• Permitting the use of testimonials, endorsements and third-party rankings in advertisements, subject to certain requirements; and
• Requiring managers to designate an employee to review and approve all advertisements, subject to certain limited exceptions.

Proposed Updates to Accredited Investor and Qualified Institutional Buyer Standards

In December 2019, the SEC proposed amendments to broaden and update the categories of natural persons and entities that qualify as “accredited investors” for purposes of private placements offered pursuant to Regulation D, including private fund offerings. As amended, the definition of “accredited investor” would include:

• Individuals holding certain professional certifications, designations and credentials, initially expected to include Series 7, 65 and 82 licenses;
• Individuals that have “knowledgeable employee” status under the Investment Company Act of 1940 (the "Investment Company Act") (i.e., high-level executives or qualifying investment personnel for private fund managers); and
• Certain new categories of entities, including any category of entity not currently covered by the definition of accredited investor (e.g., registered investment advisers and limited liability companies, non-U.S. pension plans, family offices and family office clients with more than $5 million in investments and not formed for the specific purpose of acquiring the securities being offered).

The SEC concurrently proposed expanding the definition of “qualified institutional buyer” (“QIB”) for purposes of Rule 144A offerings in order to avoid inconsistencies between the entity types that are eligible for accredited investor status and QIB status.

Privacy Laws

California’s consumer privacy law, the California Consumer Privacy Act (“CCPA”), which has gone through several changes since it was first enacted in 2018, became effective on January 1, 2020.⁶ The CCPA covers private fund managers doing business in California (regardless of physical location) with annual gross revenue in excess of $25 million, and requires such managers to update their privacy disclosures (including on consumer accessible websites) and business processes to accommodate new privacy rights for California individuals. The CCPA may also cover portfolio companies if such companies are doing business in California and exceed the $25 million revenue threshold. The CCPA exempts personal information collected and used pursuant to the Gramm-Leach-Bliley Act (“GLBA”), which is currently applicable to most private fund managers, from the scope of the CCPA. However, as the CCPA covers a broader set of personal information than the GLBA, this exemption does not wholly exempt private fund managers from compliance with the CCPA. Additional amendments to the CCPA are currently under consideration and implementing regulations have yet to be adopted. Absent a modernization of federal consumer privacy laws, we expect other states will follow California’s lead in enacting their own consumer privacy laws.⁷

Other Notable Developments

• Principal and Agency-Cross Transactions: In September 2019, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a risk alert describing recurring issues identified in examinations of managers related to principal trades and agency-cross transactions. The risk alert cited failures by managers in identifying principal and agency-cross transactions, obtaining required consent for principal transactions immediately prior to effecting such transactions and providing sufficient disclosures regarding the terms of, and potential conflicts of interest related to, principal transactions.
• Compliance, Supervision and Disclosure of Conflicts: In July 2019, OCIE issued a risk alert describing recurring issues identified in examinations related to the hiring and employment of individuals with a history of disciplinary events. Frequent deficiencies cited in the risk alert included, among other items, the failure to adequately assess the disciplinary history of potential new hires, inadequate disclosure of past disciplinary events and undisclosed compensation arrangements resulting in conflicts of interest that could have impacted the impartiality of advice given to clients.
• Safeguarding Data on Third-Party Networks: In May 2019, OCIE issued a risk alert discussing the security risks associated with storing electronic customer information on “cloud” or other similar network-based storage systems provided by third parties. The risk alert recommended that managers implement policies and procedures regarding the installation, on-going maintenance (e.g., software patches, hardware updates, etc.) and review of such systems.
• Investment Company Act Private Right of Action: In August 2019, the Second Circuit recognized that the Investment Company Act provides a private right of action to seek contract rescission for parties to a contract made in, or whose performance involves a, violation of the Investment Company Act (e.g., a private fund LPA or other contract).⁸ The decision created a circuit split as the Third Circuit and several lower courts have previously found in recent years that such a private right of action does not exist.
  
  

^{1. Concurrent with its adoption of this interpretation, the SEC adopted (i) the long-anticipated Regulation Best Interest, which establishes a standard of conduct for broker-dealers recommending securities transactions to or investment strategies involving retail customers; and (ii) Form CRS, an addition to Form ADV requiring managers to provide a brief, plain language summary of certain aspects of their operations, including conflicts of interest, to prospective and existing retail investors. As currently understood, retail investors for purposes of Form CRS would not include natural person investors in private funds.↩}

^{2. The SEC also noted that managers who recommend public securities to a fund have a duty to seek best execution of public securities transactions, with the goal of maximizing value for the fund, including a consideration of the full range and quality of a broker’s services (i.e., not solely based on the lowest cost).↩}

^{3. The SEC also noted its belief that the use of the word “may” in conflicts disclosures is inappropriate to describe a regular practice. For example, in the context of the receipt of monitoring fees from portfolio companies and the potential conflicts related thereto, if a manager regularly receives such fees then its conflicts disclosures should not state that it “may” receive monitoring fees but, instead, should indicate that the manager generally receives such fees.↩}

^{4. Concurrent with its proposed amendments to the advertising rule, the SEC proposed amendments to the cash solicitation rule under the Advisers Act. If adopted, the changes would subject private fund managers (who were previously excluded) to the cash solicitation rule. This would require managers to provide an additional separate disclosure document to fund investors regarding cash and non-cash payments made to solicitors (e.g., placement agents) in connection with fundraising.↩}

^{5. Under the proposed rule, “non-retail persons” would include qualified purchasers and knowledgeable employees (each as defined under the Investment Company Act) and “retail persons” would include all other persons.↩}

^{6. See August 6, 2019 Kirkland AIM, “Impact of the California Consumer Privacy Act on Private Fund Managers,” and August 9, 2018 KirklandPEN, “New California Consumer Privacy Act Impacts Private Equity Portfolio Companies.”↩}

^{7. The Cayman Islands also recently adopted the Cayman Data Protection Law (“CDPL”), which went into effect on September 30, 2019 and impacts managers with private funds organized in the Cayman Islands. The CDPL is generally aligned with EU GDPR requirements. See August 30, 2017 Kirkland Alert, “EU General Data Protection Regulation” and May 14, 2018 Kirkland Alert, “EU GDPR - Coming Soon to an M&A Transaction Near You.”↩}